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Curtis Mewbourne, 45, is a managing director at Pimco in New York City, where he is head of portfolio management. He oversees the
Diversified Income
Fund (ticker: PDIIX) and co-manages the
Emerging Multi-Asset
Fund (PEAAX) and the
Global Multi-Asset
Fund (PGMAX). It's the latter that caught our eye. The $5.15 billion fund, co-managed by Pimco's co-CIO Mohamed El-Erian and managing director Vineer Bhansali, focuses on risk factors, rather than traditional asset or geographical allocations. This strategy invests mostly in about two dozen other Pimco funds and aims for long-term annual returns of about 8%-10% while avoiding losses of more than 15%. So far, so good. It's averaged about a 9% annual return over its three-year lifespan, though 2011 was essentially flat. In light of the perilous outlook for 2012, we thought it was a good time to see a risk specialist.

Barron's:What's the most interesting change in the world with ramifications for investing in the year ahead?

Mewbourne: There are a couple of very important changes going on. One, which is pretty broadly accepted, is that we are seeing a very significant shift of economic importance away from the developed economies into the developing economies. The second is that we are in a world where the amount of credit extension is much higher; debt is much higher on the sovereign level than anything we've seen in the last several decades. For investors this means that strategies that had been effective in the past may not be effective in the future.

"We are in a world where debt is much higher on the sovereign level than anything we've seen in the last several decades. " -- Curtis Mewbourne
Peter Murphy for Barron's

Is that what's behind the strategy of the Global Multi-Asset Fund?

When we looked at launching the fund in 2008, we wanted an approach that would help investors navigate a very dynamic and changing global economy–one with higher levels of risk, especially higher debt levels. A couple of things made sense to us. The first is thinking about investments in terms of risk factors, rather than asset-class definitions. A risk factor is a way of measuring how an investment behaves, rather than what it is called. One example could be a bond of a company in a very strong financial position. If the company's financial position deteriorates to the point where it may even go bankrupt, that bond will turn into equity. Even though it is called a corporate bond, it is behaving like equity, so it has an equity risk factor. Another example is an oil risk factor. Whether you invest in
Petrobraspze -1.867816091954023%Petrobras Argentina S.A. ADSU.S.: NYSEUSD6.83
-0.13-1.867816091954023%
/Date(1427835723136-0500)/
Volume (Delayed 15m)
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282979AFTER HOURSUSD6.82
-0.00999999999999979-0.14641288433382138%
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1
P/E Ratio
22.067851373182553Market Cap
1905891186.88237
Dividend Yield
N/ARev. per Employee
N/AMore quote details and news »pzeinYour ValueYour ChangeShort position
[PZE] bonds or
ExxonMobilXOM -0.7357234614037137%Exxon Mobil Corp.U.S.: NYSEUSD85
-0.63-0.7357234614037137%
/Date(1427835618383-0500)/
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11947841AFTER HOURSUSD85
%
Volume (Delayed 15m)
:
1405949
P/E Ratio
11.19407899068916Market Cap
359191288161.557
Dividend Yield
3.2470588235294118% Rev. per Employee
4357980More quote details and news »XOMinYour ValueYour ChangeShort position
[XOM] or
British Petroleumbp -1.8323293172690762%BP PLC ADSU.S.: NYSEUSD39.11
-0.73-1.8323293172690762%
/Date(1427835688484-0500)/
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6156679AFTER HOURSUSD39.03
-0.0799999999999983-0.20455126566095627%
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42667
P/E Ratio
28.295470988279554Market Cap
120552648348.742
Dividend Yield
6.136537969828688% Rev. per Employee
4167260More quote details and news »bpinYour ValueYour ChangeShort position
[BP] stock or Russian or Middle Eastern government bonds, all of these securities are highly dependent on oil. Those are corporate bonds, stocks and government bonds, but they all at times can be driven by oil. So the asset-class definition may not be as useful as the risk-factor definition. The main risk factors are an equity risk, interest-rate risk, currency risk and commodity risk.

We set targets for those risks. As securities change, it will force us to adjust the portfolio. In the financial crisis, a typical investment portfolio might have been 60% equities, 40% bonds. But if a lot of those bonds were corporate bonds, it was more like 90%-plus equity at that time. If your target for your equity risk was 60%, you would need to either change the portfolio or change the target.

The second element we wanted to incorporate was using Pimco's broad platform to identify good investment opportunities. We call this an alpha strategy, and the idea is fairly straightforward. If one of our portfolio-management teams identifies a good opportunity that makes sense from an asset-allocation standpoint, we want that investment in this fund. So, for example, one of the opportunities that we thought was compelling over the past year was BP bonds, following the Deepwater Horizon crisis. We had a small investment in the
Pimco Investment Grade Corporate Bond
Fund [PIGIX is an institutional fund] at the time. But we thought it was a compelling idea, so we purchased the individual securities. We did that in Japan after the earthquake.

We also thought that there has been far too much focus on returns and not enough focus on risk. In a generally benign and less dynamic environment, it's understandable why the focus would be on returns more than risk. But we feel strongly that today risks are much higher. So, we set overall risk tolerances. We said for these types of asset-allocation strategies, investors probably expect to have some volatility. If they wanted to generate a 10% return, they are not going to be surprised if they have a 5% loss at some time. They do not want to have a 50% loss. And so we set a 15% loss objective for these funds. We said let's have a specific tail-risk hedging strategy. And we purchase tail-risk insurance. We have a budget of about 1% that we spend every year. So we insure our equity risk, our interest-rate risk, our currency risk, our commodity risk such that we don't have–our objective is not to have more than a 15% loss.

What risks have been rising?

Over the past several months, we have been reducing the risk of the portfolio in terms of exposure to European and Asian equity markets. We think that the pressures in Europe will continue into the new year. And we have been increasing exposure to gold over the course of the year. It does have some tail-hedge benefits as well as some others. There has been a very high correlation with equities. There are some large hedge-fund managers, for example, in the U.S. that have investment portfolios hedged into gold, and as the investment portfolios shrink, they need to sell gold. We think at a certain point that will disengage. We also have been, over the past several months, significantly increasing the tail-risk portfolio by pre-buying insurance, given what we think are relatively attractive levels. So for equity volatility levels, the VIX is low relative to what we perceive to be the global risks. We also think levels in some currencies, whether it is in the puts on the euro or puts on the Australian dollar, are also priced attractively, relative to the potential downside.

What are the implications of the jump in sovereign debt?

One is the changing nature of government debt. In many cases, government bonds were thought to be risk-free investments with a guaranteed return of principal. Rating agencies would rate these triple-A securities. Now we are seeing many countries that were believed to be triple-A, including the United States, being downgraded. Traditionally, emerging-market government bonds, because of historically high debt levels or weaker domestic institutions, had a significant chance of not returning your principal. Fast forward to today, and many reasonable people could sit in a room and say that the credit quality of many emerging-market countries is higher than, or improving and converging on, the credit quality of many of the developed-market countries. And so, formerly risky bonds become less risky, formerly risk-free bonds are becoming riskier.

Key Portfolio Shifts in 2011

Pimco's Global Multi-Asset Fund made about a half-dozen moves to take advantage of, or protect itself against, events around the globe. The European crisis prompted a few.

We think that some opportunities away from Europe are interesting. The government bond markets in Australia and Canada are attractively priced. In addition, we think some of the emerging-market countries, those that were formerly viewed as more risky credits and are becoming higher quality, also offer some compelling opportunities. Government bonds in Brazil and government bonds in Mexico would be examples.

Brazil's slow growth and inflation don't worry you?

Certainly, all the economies are connected in the global world, so if we see a very sharp slowdown in global economic activity or a crisis in Europe, could that spill over to other countries? Yes. But on the flip side, when we look at current interest rates, those countries are some of the few places where we are getting interest rates on the bonds that are higher than inflation. In the case of Brazil, it's an 11% yield versus inflation that is running 7% or less. Further in Brazil and in other emerging-market countries, we are seeing interest-rate cuts. So that those bond markets actually have the potential to increase in price as yields go down. Contrast that with the very low interest rates that we have in the U.S. or Germany. So, yes, there is some risk. We would not argue that emerging-market fixed income is risk free. But we think that, given where the markets are priced, and given our forward expectations for lower interest rates in some of those countries, we think the risk/return [ratio] is attractive.

Do your expectations for equities follow the same idea of emerging markets versus developed markets?

Very much so. Within our global multi-asset fund, one of the secular themes you will see is an allocation of capital to the faster-growing parts of the world. So we have a large investment in emerging-market equities within our equity allocations and our equity investments. Within our global multi-asset fund for this year, we had almost all of our equity exposure within the United States and emerging markets. And very little exposure to developed Asia and Europe—less than 6%.

What about U.S. bonds?

The U.S. bond market has very much benefited from a flight to quality–what [Pimco Co-CIO] Bill Gross calls the "cleanest dirty-shirt" phenomenon. While the U.S. debt levels are certainly high, financial markets have witnessed a shifting of investments away from European government bonds, away from some of the European, Asian and emerging equity markets and the U.S. bond market has been a beneficiary. So as long as risk aversion remains high—and our expectation is that, given the potential problems in Europe, risk aversion will remain high—the U.S. bond market will continue to benefit from this flight to quality.

And U.S. corporate bonds?

When you think about balance sheets in the U.S., the corporate sector is in a stronger position than, say, the government or the consumer. Corporations, especially multinationals, have been able to take advantage of growth in the faster-growing parts of the world. They've gone through some periods of financial stress–in the early 2000s in the dot-com selloff and the financial crisis in 2008 and 2009. Corporate managers in many cases have been looking to build cash reserves, reduce their debt burdens. As a result, corporates are in a relatively strong position in terms of credit quality. Current spreads reflect some amount of risk aversion. So we think that, in many cases, the spreads for higher-quality corporate bonds are more than compensation for potential losses from defaults. Up in the capital structure—meaning the senior debt—looks relatively attractive versus lower in the capital structure–either subordinated debt or equity-type investments.

And if you had one or two things from last year that you could do over, what would they have been?

The things that we got right were avoiding European and Asian equities. I think that our longer-term focus on emerging equities hurt us. So, while we are still comfortable with the forward expectations, emerging equities certainly did not do as well as U.S. equities last year. The second area would be having a larger exposure to U.S. Treasuries, which benefited from the flight to quality. Our view earlier in the year was that further price appreciation was limited with yields already very low. Yet we saw continued lowering of yields and price appreciation as the flight to quality increased.